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Tuesday, June 28, 2016

Fitch and Standard & Poor's both downgraded the U.K. to AA (from AAA) this week in response to the Brexit vote (politico.eu article). As experienced market watchers would expect, U.K. gilts have been rallying (yields falling), which is not the usual narrative that one hears about ratings actions. This article explains why bond investors treat credit ratings for free-floating developed sovereign governments as sources of entertainment, and not investment guidance.

Understanding Government Finance (paperback edition just released!), developed sovereigns with a free-floating government are not at risk of involuntary default; rather the risk is of voluntary repudiation of debt. Although some investors have been slow learners about this reality -- take the parade of JGB shorts -- most government bond investors have accepted this reality.

Although credit ratings are unfortunately worked into bond indices, bank regulations treat the sovereign issuer as special, with a 0% risk weighting, Furthermore, everyone knows that the government cannot be forced to default. This knowledge either comes from something resembling Modern Monetary Theory's analysis of governmental finance operations, or the more primitive "they can just print the money."

Some international investors could be dissuaded from investing due to a rating action, but such investors are inevitably tourists. No matter the size of their total portfolios, their exposure to an individual country is going to much smaller than domestic investors, whose portfolios are concentrated in the local currency. (The United Kingdom was notoriously treacherous for relative value investors from overseas; trading was dominated by a small club of large local institutions, and what appeared to be mispricing to outsiders was just a reflection of position jockeying amongst those players. Unless you understood what was going on, there was a good chance you would end up being run over like a steamroller.)

As a result, bond yields follow rate expectations, and not rating agency opinions.

Moreover, the ratings agency justification for these moves makes very little sense. The Brexit referendum had no bearing whatsoever on Britain's willingness to make good on its bonds. One could perhaps argue about the possibility of the secession of Scotland leading to disputes over debt repayment, but that is a far-fetched possibility. The only justification for the ratings move was to create headlines as a form of cheap publicity for the ratings agencies.

The downgrade of the United States during the debt limit standoff was at least somewhat justified; after all, the dispute could have led directly to a default (although those in favour of not lifting the debt limit strenuously argued that it would not lead to default; the belief was that spending would be cut to preserve the limit). In that case, there at least was a question about the willingness to pay (a point that Warren Mosler emphasised at the time).

Real Risk Is Inflation, Which Is Not The Rating Agency Mandate

With floating currency sovereigns, the real risk is inflation, not default. (Some crackpots lump inflation in with "default," which utterly destroys the meaning of default, which is a breach of contractual obligations.) Although rating agencies sometimes nod to inflation risk when they make up their sovereign ratings, they do not cover it. After all, if they did use that metric, Japan would have the best credit rating on the planet, which messes up fireside scare stories about the debt-to-GDP ratio.

Where "Government" Ratings Matter

If countries are borrowing in a foreign currency, they can default like any other "user of the currency." This also applies to the euro zone, as the individual nations no longer have control of the central bank. In the post-1980 era, such countries (outside Europe) tend to be emerging markets. For such sovereigns, I have not seen evidence that rating agency ratings are worse than any other source of information on default risk.

Additionally, for sub-sovereigns, ratings can be useful. These are also entities that have a track record of defaulting, and so the rating agencies have actual default data to calibrate against. (The lack of free-floating sovereign defaults explains why the rating agencies have a difficult time with them; they work best using historical default studies. Lack of default data is also the excuse used for the ratings failures with securitisations before the Financial Crisis.)

If you look at Canadian provinces, spreads were somewhat related to ratings. (That partially reflected the reality that ratings followed spreads with a lag.) Nobody serious has been concerned about defaults (although secession has periodically been an issue), but a rating cut would be a technical factor that leads you to expect a wider spread.

At the minimum, retail investors probably prefer higher-rated bonds, and they matter in the illiquid provincial bond market. This illiquidity means that the bonds can trade at a reasonable spread (100 basis points, say) even when the expected default risk is nil.

However, the rating is not the most important technical factor. Some provinces are quite small, and their bonds outstanding are negligible in size. The premium for illiquidity for these bonds can be much more significant than the effect of their credit rating. (Illiquidity explains why Canada Mortgage Bonds (CMB's) can trade at a decent spread over Government of Canada bonds, even though CMB's are a full faith and credit obligation of the same issuer.)

2 comments:

Great Post! Looking forward to the book! Mr. Romanchuk (Brian), do you also teach any classes? I understand you live on the South Shore, so you could easily teach at University de Sherbrooke in Longueuil or McGill or Concordia, but that does not seem to be in your bio.

Thanks. The upcoming paperback (Understanding Government Finance) is available already as an ebook; it's just that I had not figured out how to format it as a paperback (and then other things got in the way). I will be raising my ebook prices slightly fairly soon.

I taught at McGill (in Engineering) as a post-doc before I went to work in finance. I already do some consulting work, so I have not looked into teaching a course.

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